Rules of Risk Management for Currency Traders
When people think of risk management in the context of currency trading, the natural tendency is to focus on the risk of losing money. There are no two ways about it, this is the ultimate risk. But traders can head to many different streets before they reach their final profit or loss address.
How you navigate your risk paths is as much related to the outcome of your trading as it is to whether or not you will reach your final destination. Here are ten practical risk management rules to guide you in your forex trading.
Trade with stop loss orders
Stop-loss orders are the ultimate tools for reducing risk. (The exception is data/events where your stop-loss executions may experience significant slippage. Avoid this risk by not holding positions in the newsletters.) If you are trading without stop-loss orders, you are exposed to almost unlimited risk.
Always place a stop loss order for each open position, and move the stop loss only to protect profits. Do your analysis and risk calculations before entering a trade, then stick to your trading plan.
Minimum leverage
The size of the position will ultimately determine the amount of financial risk you are exposed to – the larger the position, the higher the risk. Don’t be attracted to high leverage ratios and take a position that is too big. Trading a position that is too large for your available margin reduces your cushion against routine adverse price movements. Keep your leverage to the minimum required to trade your strategy.
You can request a lower leverage percentage from most forex brokers to systematically limit your use of leverage. Just because they offer 50:1 or 100:1 leverage doesn’t mean you have to use them all.
Trade with a plan
The best way to limit the inevitable emotional reactions that come with trading is to develop a complete trading plan from entry to exit (stop loss and take profit) before you open a position. Committing yourself to creating a trading plan for each strategy will also prevent you from speculating on a whim or over-trading (always having an open position).
Of course, no trading plan will work if you don’t follow it, which brings us back to human risk in trading. You have a much better chance of sticking with a trading plan if you have developed one in the first place.
Stay on top of the market
Make sure you have a solid understanding of what is happening in the market and the currency pair you are trading. Find out what data and events are scheduled for the coming days and weeks. Consider the liquidity conditions during the time horizon of your trading plan.
What has the market priced and priced? Anticipating market events and conditions will not guarantee a winning trade, but it will alert you to potential turbulent conditions that you can introduce into your trading plan to reduce your overall risk.
Trade with advantage
The currency market is traded around the clock, but that doesn’t mean you have to be in it all the time. Choose your places, choose your timing; Don’t be attracted to noise. Keep your ammunition dry, and look for trading setups with a clearly defined risk/reward scenario.
Be pushy, and spend your time and effort looking for trading opportunities that are still coming rather than getting caught up in the market movement at the moment. Other opportunities will surely be developed, and you will be ready for them.
Back off the market
When you’re not in the market, a funny thing happens: your point is clearer; Your objectivity is at its peak; You are not emotionally invested in a market situation. Make it a point to balance and pull back from the market on a regular basis. Use your downtime to follow charts and fundamental analysis.
Take a complete vacation and forget about the markets for a while. When you come back, you will be refreshed, thinking more clearly, and ready for new trading opportunities.
Take profits regularly
Taking profits regularly is the surest way to reduce risk. By definition, if you make a profit – even a partial profit – you reduce your exposure to market risk. Your trading plan may have a more robust profit target, but if market events play to your advantage, it is beneficial to protect what you have gained by taking partial profits or adjusting your stop loss orders to lock in some gains.
It may be a coincidence that the market jumped 40 pips in your favour when the data was released, or it could be a coincidence that the market fell again by 50 pips ten minutes later. The only way to be sure is to take some profits. You cannot go bankrupt to take a profit.
Understand the choice of currency pairs
Market risk varies greatly from one currency pair to another, based on volatility, liquidity, data sensitivity, and many other factors. Each currency pair brings its own characteristics to the table, requiring different analytical tools or strategic approaches.
Different currency pairs also carry higher or lower margin uses and pip values. Make sure you understand the currency pair you are trading and that your trading plan reflects the characteristics of that pair.
Double check for accuracy
Currency trading is a fast-paced environment that is achieved faster through electronic trading. The risk of human error in entering trades and orders is always present and requires diligence on your part to avoid costly errors. The stop loss order will not help if it is entered in the wrong currency pair or the wrong amount.
Make it a part of your routine to review every trade and enter an order you make, ideally before you submit it but at least right after you make it. Mistakes happen to everyone, but only careless traders allow minor mistakes to pass and become major disasters.
Take money from your trading account
This is one that you will not see in many trading books: if you have made some money in the market, make periodic withdrawals from your trading account. We call it taking money off the table. If your profit remains in your margin account, it is subject to future trading decisions, which presents an unknown risk. Keep your margin balance at a level that allows you to trade at your own volumes.
Also remember why you are trading – it’s not just about the money, but what you can do with it. Withdraw your winnings, and spend or invest them the way you always said you would.